Educational Articles

Sector Analysis - April 9, 2012

Robert Mitkowski, Jr.
| April 09, 2012

Investors who want to look at the "big picture" often start by examining the state of the economy and the stock market in general, and then look, in order, at market sectors, at industries within a sector, and then at companies within a given industry.

This week, Value Line provides its quarterly update on the 10 sectors we follow, which include nearly 100 industries, highlighting any notable changes. The sectors are based on the Timeliness ranks of the individual stocks within the sectors, and are positioned from 1 (Highest) to 10 (Lowest) in order of attractiveness. This report also reviews updated sector price-earnings ratios and dividend yields.

A Review of the Ranks

We start out by noting that the three leading sectors for Timeliness-Energy, Industrial, and Basic Materials-are more aggressive groups, with higher betas, and these market segments are those that one would expect to perform well during a period of decent global economic growth. That is in contrast to the more defensive sectors of the stock market-such as, Utilities and Consumer Staples-that hold up better when an expansion stalls or a recession takes hold.

As for specifics, the Energy sector has moved to the top of the list for Timeliness, as seen in the nearby table, up from third three months ago. With geopolitical tensions threatening supplies, rising oil prices are a plus for the group, and shares of oil-producing companies stand to benefit. Petroleum demand is also moving ahead on the strength of increased requirements from developing nations. Upbeat prospects for the Energy sector are not all encompassing, though, given decade-low natural gas prices.

Now ranked second for Timeliness, the Industrial sector has also advanced two notches in Timeliness since December. Solid gains in manufacturing have helped fuel the group's profits in recent months. Part of the improvement is likely related to inventory restocking, but those extra stockpiles, and more, could be needed if job growth continues and the economic expansion picks up.

On the down side, the Basic Materials and Utilities sectors have each fallen two notches in Timeliness. Basic Materials shares lost some luster when China announced that it was targeting a lower rate of GDP growth, pointing to an uneven recovery. The lack of further monetary stimulus on the part of the Federal Reserve has also dampened enthusiasm a tad for basic materials stocks, although the group remains well ranked overall.

Meanwhile, the drop in Timeliness for the Utilities group reflects slowing price momentum and a shift in investor preferences. Utility stocks were the big winners in 2011, when market volatility, driven by the uncertainty over the future of the euro zone, pushed investors into perceived safe havens. Some of the large-cap telecom stocks are still seen as defensive holdings, too. That partly accounts for the drop in the Telecommunication sector's Timeliness rank.

Confidence Back on the Rise

Six months ago, the stock market's median P/E was close to 13.5, materially lower than the current 15.6 reading, when fears were greater that the sovereign debt crisis in Europe would lead to a recession in the United States. But prior to last summer's stock market selloff, the market P/E was near 16.0.

Recent sector price-earnings ratios are within their long-term ranges, although with some of the typical ebb and flow. For instance, while valuations in general have eased since the market selloff last summer, that has not held true for the Technology, Telecommunications, and Utilities groups. The Utilities sector's valuation is near the high end of where it usually trades, despite some backtracking this year as growth-oriented sectors, such as Tech, have gained favor. Utilities stocks continue to enjoy more of a premium valuation than usual, owing to the low interest rate environment that looks as if it may remain in place for the near future.

On the flip side, the energy sector's P/E ratio has come down in the past year as shares of companies that produce natural gas or coal have been hurt by lower prices. The drop in the energy sector's P/E reflects less confidence that earnings achieved across the group as a whole over the past 12 months can be sustained.

Overall, sector valuations are not out of line, given good prospects for a continuation of the modest economic recovery and a healthy respect for the dangers (rising oil prices, another round of euro zone troubles) that could push the business upturn off course.

Keep Those Dividends Coming

Token yields on cash and bonds continue to push investors towards stocks that pay good dividends. As we see in the table nearby, the Utilities sector is easily the highest yielding of all. Electric utilities, as a group, were recently yielding 4.3%, more than the 3.9% yield offered by natural gas utilities. The higher yield for the electrics is partly because the stock prices of certain power generators have lagged, owing to low electricity prices. The estimated median yields for the remaining industries in the sector are: Oil/Gas Distribution, 3.4%; Water Utility, 3.0%; and Telecom Utility, 7.5%.

Outside of Utilities, no individual sector stands out for its high yield. However, the Technology sector is becoming more known for income-producing stocks as it matures.

Notably, too, the Financial Sector is coming back on the radar screen for investors looking for dividend growth. Prospects for dividend hikes have improved, particularly for banks that passed their recent stress tests administered by the Federal Reserve.

That said, income-oriented investors usually desire a healthy dose of stability with their stocks. Consequently, we advise investors to take into account each stock's Safety rank. Stocks 1 or 2 for Safety by Value Line offer greater price stability from shares of companies with stronger finances than most.

At the time of this article's writing, the author did not have positions in any of the companies mentioned.